In light of recent SEC enforcement and private class action litigation developments regarding sub-advised mutual fund fees, mutual fund boards and management companies should review and consider ways to enhance their investment advisory contract approval process pursuant to Section 15(c) of the Investment Company Act of 1940, as amended (the "Act"). This article will discuss a number of strategies that can enhance the Section 15(c) process.1
Both the SEC and private plaintiffs' bar have focused recently on sub-advised fund fees. The SEC brought an enforcement action last year against an investment adviser that hired a sub-adviser to help it manage a Malaysian sector fund.2 The SEC alleged that the adviser represented to the board that the sub-adviser was providing services to the fund and recommended that the board approve the sub-advisory contract, even though the sub-adviser provided no real services to the fund. The SEC's enforcement action alleged violations of Section 15(c) and other securities laws. At the same time, the plaintiffs' class action bar is pursuing a new theory of liability against sponsors of sub-advised funds, alleging that they receive a disproportionately large portion of the investment advisory fee while the sub-adviser purportedly does most of the work.3
Advisers should structure their Section 15(c) presentations to disprove the primary factual premise in the recent class action lawsuits against managers of sub-advised funds: that the investment adviser performs little or no services in connection with the fee that it receives. Investment advisers in fact perform a variety of functions in the course of overseeing sub-advisers, including: researching and selecting the sub-advisers; performing due diligence on the sub-advisers from an investment process, operational and compliance perspective; portfolio construction (that is, combining multiple sub-advisers, and allocating fund assets among them, in a manner designed to serve fund investment objectives); monitoring their ongoing performance; ensuring compliance with the investment objectives of the fund and consistency with the fund's disclosures; oversight of third-party service providers; and reporting to the fund board, to name a few.
If the investment advisory contract does not clearly delineate the responsibilities of the investment adviser, however, the adviser should consider ways it can clarify for the board and the record the work it performs pursuant to its advisory contract. One way would be for management to clearly specify (for example, in the Section 15(c) meeting board materials) the various services it actually performs for the funds, and differentiate these services from those performed by the sub-adviser. Another approach would be to
amend the investment advisory agreement to specify the responsibilities of the investment adviser. Before undertaking such an amendment, however, it would be necessary to determine whether the amendment would be material and require a shareholder vote under Section 15(a).
Enhancing the Contract Approval Process
Management and boards should consider ways that they can improve upon their process and address some of the concerns raised by the SEC and plaintiffs' bar about mutual fund fees in general and sub-advised fund fees in particular. The case law under Section 36(b) and SEC disclosure rules in this area provide a framework for considering how to improve the Section 15(c) process.
Care and Conscientiousness of the Board
In both Gartenberg4 and Jones v. Harris, the courts focused on the role of the board, the care and conscientiousness with which the directors approached the contract review process, and their independence.5 Courts and the SEC are most likely to defer to the business judgment of boards where the record demonstrates that a thorough review process took place, the board reviewed all of the information necessary to evaluate the investment advisory contract, and the board asked relevant questions and received meaningful responses from management.
Section 15(c) places an affirmative obligation on the board to request and evaluate such information as may reasonably be necessary to evaluate the terms of the investment advisory contract and requires that the investment adviser furnish such information to the board.6 Boards typically fulfill their obligation in a written request to the management company prepared by board or fund counsel. Boards should review this letter with counsel to make sure that their request is well-crafted to capture all of the relevant information based on each fund's particular circumstances. Boards and counsel should update the request to reflect developments during the year, including any performance, compliance or asset flow issues with particular funds. If the board of a sub-advised fund does not clearly understand the allocation of responsibilities between the investment adviser and the sub-adviser, they should ask the adviser for clarification.
Boards and management should consider the best way for their fund group to structure their 15(c) meetings, given the complexity of review and time and resource constraints on directors and management. For some fund groups, a single meeting may be sufficient, but other groups may prefer to spread the process over two or more meetings to allow for a more thorough discussion of issues requiring in-depth analysis and follow-up. Another option is to create a contract review committee of the board that meets throughout the year and is able to delve more deeply into substantive questions. Other fund groups may allocate among the directors responsibility for more focused attention on particular funds, assigning each director responsibility for reporting on several funds at the contract approval meeting, given the complexity of review and time and resource constraints on directors and management. For some fund groups, a single meeting may be sufficient, but other groups may prefer to spread the process over two or more meetings to allow for a more thorough discussion of issues requiring in-depth analysis and follow-up. Another option is to create a contract review committee of the board that meets throughout the year and is able to delve more deeply into substantive questions. Other fund groups may allocate among the directors responsibility for more focused attention on particular funds, assigning each director responsibility for reporting on several funds at the contract approval meeting.
The independent directors should make sure the agenda for the meeting includes ample time to meet among themselves with their counsel to review management's presentation and identify issues for further inquiry. They should also make sure that they receive the board materials well in advance of the meeting to allow for a thorough review. The board should have a process for asking questions and communicating them to management through a single point of contact, such as a lead independent director or independent directors' counsel. Independent directors may also find it helpful to schedule time prior to the meeting to discuss the materials and raise questions for management to address at the meeting.
Management can enhance the board's effectiveness by proactively identifying issues and raising them with the board. If the management company knows that a fund has challenges under one or more of the Gartenberg factors (for example comparatively high expenses relative to peers combined with poor relative performance), it should bring that to the attention of the board and provide an explanation that addresses the board's concerns, or it should explain what steps it is taking to address the issues.
Nature, Extent and Quality of the Services Provided by the Adviser
Management should explain to the board how the services it performs add value to the sub-advised fund structure. If there are specific functions that the adviser performs, such as managing cash, allocating assets among multiple sub-advisers, or performing compliance testing for the portfolio, these should be explained. Management should maintain policies and procedures regarding the oversight of sub-advisers and other service providers, and keep records that demonstrate those services were actually performed during the year. Management should highlight for the board relevant information demonstrating the quality of the services it provides, including shareholder satisfaction surveys, industry awards, and other recognition from unbiased sources, such as the media and independent mutual fund research firms.
Investment Performance of the Fund and Adviser
Boards should compare their fund's performance with that of an appropriate peer group and an appropriate benchmark. Boards often hire independent firms such as Morningstar and Lipper to prepare this information. The vendors that assemble these peer groups are not infallible, and management should discuss with the board any peer funds that it believes should not be in the group. For example, two funds in the same peer group may have similar investment objectives, but may utilize strategies with very different risk profiles. The board and management should also consider what are the most appropriate performance time periods to review (for example, one-, three-, five- or 10-years), based on their investment philosophy, investor time horizon, and other relevant considerations.
Costs of the Services Provided and Profitability of the Adviser
The courts have cautioned not to place too much emphasis on fund expense comparisons because mutual funds generally do not change investment advisers, and therefore competition to reduce fees
may be lacking.8 Still, this factor continues to receive attention, and a fund with higher expenses relative to peers should prompt further inquiry by the board. All else being equal, an outlier fund with higher expenses relative to peers is more likely to draw the attention of regulators and the plaintiffs' bar.
There may be good explanations as to why a sub-advised fund may be more expensive than its peers, including the fact that high quality sub-advisers can command higher fees. Also, an investor in a sub-advised fund may be getting a better overall product, especially where the adviser is adept at researching and selecting the best sub-advisers or allocating assets among a group of sub-advisers that results in a portfolio with superior risk-adjusted performance. Management should explain to the board why higher than peer expenses are justified by superior services or better risk-adjusted performance. As with performance peer groups, if management believes that particular funds are not appropriately included in the expense peer group, or that relevant funds were inappropriately excluded, it should raise that with the board. In certain circumstances it may be appropriate for management, in consultation with the board, to create a custom peer group.
Profitability and cost accounting, the courts have said, is "an art rather than a science."9 Cost accounting systems that management relies on for business planning and accounting purposes likely will be given more weight by courts than systems that are used solely to calculate profitability for Section 15(c) purposes. Management and the board should evaluate the cost allocation methodologies in order to satisfy themselves that cost allocations to the investment advisory business are appropriate. An internal review by the firm's accounting department may help the board understand the cost allocation process. Some firms hire outside accounting firms to perform an analysis of the cost allocation methodology.
It is also important when evaluating profitability to allocate revenues properly to the investment adviser's business. Management is required to disclose and the board should evaluate any "fall-out" benefits that the adviser or its affiliates would not have earned but for the investment advisory relationship with the mutual fund.10 For example, the courts have held that float revenue earned by investment advisory affiliates on free credit balances awaiting sweep into a money market fund should be considered as a fall-out benefit of the adviser's contract with the money market fund.11
Extent to which Economies of Scale Are Realized as the Fund Grows
As fund assets grow, the fund may experience economies of scale. These economies of scale ordinarily should be shared with investors, for example, through reductions in advisory fees as fund assets reach specified levels (breakpoints). The first question that needs to be answered, however, is whether the adviser is experiencing economies of scale as a fund increases in size. The courts have defined economies of scale for purposes of Section 36(b) to mean decreasing unit costs as fund assets increase in size.12
In order to address this Gartenberg factor, the adviser must determine what the appropriate drivers of cost are, and whether unit costs are actually decreasing as fund assets grow. For example, if the number of accounts in a sweep money market fund is increasing proportionately with the increase in fund assets, and the number of sweep transactions per account remains constant, the unit costs might not decrease if the primary driver of cost is the number of transactions in the fund.
Similarly, if a fixed income fund is forced to invest in a larger number of issuers as its assets grow, and that increasing number of issuers requires a larger number of research analysts to evaluate new issuers, its per unit costs may not decrease due to the added research expenses.13 Conducting this analysis is important for fund companies that experience significant asset growth. In the sub-advised model, there may be fewer opportunities for economies of scale depending on the ability of the adviser to negotiate fee reductions with the sub-adviser. Portfolio management is a variable, rather than fixed, cost.
Whether Fee Levels Reflect Economies of Scale for the Benefit of Investors
The courts have held that economies of scale can be reflected in fund fees in different ways. Breakpoints, or reductions in the investment advisory fee as assets reach specified levels, are a common way for fund managers to pass along economies of scale to investors. Alternatively, the manager may set fund
fees low to begin with and not have breakpoints because the low fee incorporates economies of scale throughout the life of the fund.14 The manager may pass along economies of scale to investors by increased investment in infrastructure and staffing, resulting in improved fund performance. Waivers of fees and contractual expense limitations are another way that managers may pass along economies of scale to investors.
To the extent that the management company actually experiences economies of scale with respect to its management of a fund, it should disclose that to the board and explain how it has shared those benefits with shareholders. Management and the board should satisfy themselves that the benefits are reasonable in relation to the amount of economies of scale.
Comparable Products Analysis
Management and the board should make sure that they review the investment advisory fees of mutual funds managed by the investment adviser with any comparable products it manages. In Jones v. Harris, the court refused to set forth a categorical rule that comparisons between mutual fund fees and institutional account fees are never relevant, and instead ruled that each case must be determined based on the facts and circumstances.15
The management company should identify any products that are arguably comparable and, if applicable, explain to the board how the services provided to institutional or other clients are materially different from those provided to mutual fund clients. Management companies have identified a number of differences in services and business expenses between managing retail mutual funds and institutional accounts, including: the heightened regulatory, compliance, and disclosure burdens for mutual funds; the need for managers to hire specialized personnel who are fully or substantially dedicated to mutual fund operations; the added burden of oversight of mutual fund service providers such as transfer agent, distributor, fund accountant, fund administrator, auditor and legal counsel; the greater class action litigation risk with respect to mutual funds as compared to institutional accounts; the added difficulty of managing a portfolio to be able to meet daily redemption requests from retail mutual fund investors as compared with the relatively stable asset base of institutional investors; and others.
Enhancing the contract renewal process may significantly improve the record that a court or regulator will be asked to review in the context of a lawsuit or investigation. If the board can demonstrate that it exercised appropriate diligence in evaluating all of the relevant information in approving the investment advisory contract, it will enhance the likelihood that a court or regulator will defer to the board's sound business judgment.
1 This article is an abridged version of an article that appeared in the June 2012 edition of The Investment Lawyer, available at http://www.dechert.com/Enhancing_the_Investment_Advisory_Contract_Review_Process_ Can_Mitigate_Recent_Increased_Litigation_and_Enforcement_Risk_of_Sub-Advised_Funds_06-01-2012/.
2 In the Matter of Morgan Stanley Inv. Mgmt. Inc., Advisers Act Rel. No. 3315, 2011 WL 5562535 (Nov. 16, 2011).
3 See, e.g., Sivolella v. AXA Equitable Life Ins. Co., No. 11-CV- 4194 (D.N.J. filed Jul. 21, 2011); Curran v. Principal Mgmt. Corp., No. 09-CV-433 (S.D. Iowa filed Oct. 28, 2009); Southworth v. Hartford Inv. Fin. Servs., LLC, No. 10-CV-878 (D. Del. Filed Oct. 14, 2010).
4 Gartenberg v. Merrill Lynch Asset Mgmt., Inc., 694 F.2d 923 (2d Cir. 1982). Under the Gartenberg standard, a plaintiff must prove that the fee was so disproportionately large that it bore no relationship to the services rendered and could not have been the result of arms-length negotiation. Jones v. Harris Assocs. L.P., 130 S. Ct. 1418 (2010).
5 Id. (citing Gartenberg, 694 F.2d at 930).
6 15 U.S.C. Â§ 80a-15(c).
7 Jones, supra n.4, at 1429.
8 Krinsk v. Fund Asset Mgmt., Inc., 875 F.2d 404, 412 (2d Cir. 1989), cert. denied, 493 U.S. 919 (1989).
9 Gartenberg, supra n.4.
11 Krinsk, supra n.8; Kalish v. Franklin Advisers, Inc., 742 F. Supp. 1 222, 1238-41 (S.D.N.Y. 1990), aff'd, 928 F.2d 590 (2d Cir. 1991), cert. denied, 502 U.S. 818 (1991).
12 See Kalish, Id.
13 Id. at 1239.
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